Economics and Liberating Theory - Part 4 doc

4 Markets: Guided by an
Invisible Hand or Foot?
Adam Smith and his disciples today see markets working as if they
were guided by a beneficent, invisible hand, allocating scarce
productive resources and distributing goods and services efficiently.
Critics, on the other hand, see markets working as if they were
guided by a malevolent, invisible foot, misrepresenting people’s pref-
erences and misallocating resources. After explaining the basic laws
of supply and demand on which economists of all stripes more or
less agree, this chapter explains the logic behind these opposing
views and points out what determines where the truth lies.
HOW DO MARKETS WORK?
If we leave decisions to the market about how much to produce, how
to produce it, and how to distribute it, what will happen? Only after
we know what markets will do can we decide if they are leading us
to do what we would want to, or misleading us to do things we
should not want to do.
What is a market?
A market is a social institution in which participants can exchange
a good or service with one another on terms they find mutually
agreeable. It is part of the institutional boundary of society located
in the economic sphere of social life. If a good is exchanged in a
“free” market, anyone can play the role of seller by agreeing to
provide the good for a particular amount of money. And anyone can
play the role of buyer by agreeing to purchase the good for a
particular amount of money. The market for the good consists of all
the potential buyers and sellers. Our analysis of the market consists
of examining all the potential deals these buyers and sellers would
be willing to make and predicting which deals will occur and which
71
ones will not. We do this by using four “laws” concerning supply

and demand.
The “law” of supply
The first “law” we use to analyze a market is called the law of supply
which states that in most markets we expect the number of units of the
good suppliers will offer to sell to increase if the price they receive for the
good increases. There are two reasons for this: (1) At higher prices
there are likely to be more suppliers. That is, at a low price some
potential suppliers may choose not to play the role of seller at all,
but at a higher price they may decide it is worth their while to “enter
the market.” So, at higher prices we might have a greater number of
individual suppliers. (2) Individual suppliers who were already
selling a certain quantity at the lower price may wish to sell more
units at the higher price. If the individual seller produces the good
under conditions of rising cost – i.e. the more units they produce
the more it costs to produce another unit – a higher price means they
can produce more units whose cost will be covered by their selling
price. Or, if the seller has a fixed amount of the good in hand they
may be induced to part with a larger portion of it once the price is
higher. In any case, the “law of supply” tells us to expect the quantity
of a good potential suppliers will be willing to supply to be a positive
function of price.
The “law” of demand
The second “law” is the law of demand which states that in most
markets we expect the number of units of the good demanders will offer
to buy to decrease if the price they have to pay increases. There are two
reasons for this as well: (1) At the higher price some who had been
buying before may become unable or unwilling to buy any of the
good at all, and may therefore “drop out of the market.” So at higher
prices we may have a smaller number of individual demanders. (2)
Individual demanders who continue to buy may wish to buy fewer

units at the higher price than they did at the lower price. If the
usefulness of the good to a buyer decreases the more units they
already have, the number of units whose usefulness outweighs the
price the buyer must pay will decrease the higher the price. So the
“law of demand” tells us to expect the quantity of a good potential
buyers will be willing to buy to be a negative function of price.
It is important to understand that these so-called “laws” should
not be interpreted like the laws of physics. No economist believes
72 The ABCs of Political Economy
that the demand of every individual demander in every market
decreases as market price rises, or that the amount every seller offers
to supply in every market increases as market price rises. In other
words, economists recognize that individuals may well “disobey” the
“laws” of supply and demand. Moreover, there may be whole
markets that disobey these laws at particular times, so that market
supply fails to rise, or market demand fails to fall when market price
rises. Markets for stocks and markets for currencies, for example,
display annoying propensities to violate the “law of supply” and
“law of demand.” A rise in the price of Amazon.com stock can
unleash a rush of new buyers who demand more of the stock antic-
ipating further increases in price, and can shrink the supply of sellers
who become even more reluctant to part with Amazon.com while
its price is increasing. The “laws” of supply and demand certainly do
little to help us understand stock market “bubbles.” In 1997 a drop
in the price of Thailand’s currency, the bhat, triggered the Asian
financial crisis when buyers disappeared from the market afraid to
buy bhat while its price was falling, and sellers flooded the market
hoping to unload their bhat before it fell even farther in value.
Clearly the “laws” of supply and demand are not going to help us
understand the logic behind currency crises. We will take up these

Markets 73
Figure 4.1 Supply and Demand
“annoying” anomalies when market participants interpret changes
in market prices as signals about what direction a price is moving in
when we examine disequilibrating forces than can operate in
markets later in this chapter. But for now it is sufficient to note that
the “laws” of supply and demand should be interpreted simply as
plausible hypotheses about the behavior of buyers and sellers in
many markets under many conditions.
At this point economists invariably use a simple graph to illustrate
the laws of supply and demand. We plot market price on a vertical
axis and the quantity, or number of units all potential suppliers, in
sum total, would be willing to supply in a specified time period on
the horizontal axis. According to the law of supply as we go up the
vertical axis, at ever higher prices, the number of units all potential
suppliers would be willing to supply in a given time period, or the
“market supply,” increases. This gives us an upward sloping market
supply curve, or in different words a market supply curve with a
positive slope. Similarly, we plot market price on a vertical axis and
the quantity, or number of units all potential demanders, in sum
total, would be willing to buy in a given time period on the
horizontal axis. According to the law of demand as we go up the
vertical axis, at ever higher prices, the number of units all potential
demanders would be willing to buy, or the “market demand,”
decreases. This gives us a downward sloping market demand curve,
or in different words, a market demand curve with a negative slope.
While these are logically two separate graphs illustrating two
different “laws” or functional relationships, since the vertical axis is
the same in both cases, and the horizontal axis is measured in units
of the same good supplied or demanded in the same time period, we

can combine the two graphs into one with an upward sloping
market supply curve and a downward sloping market demand curve.
In this most familiar of all graphs in economics one must remember:
(1) the independent variable is price, and this is measured (uncon-
ventionally) on the vertical axis, while the dependent variable,
quantity supplied or demanded by market participants, is measured
(unconventionally) on the horizontal axis. (2) When using the
market supply curve the horizontal axis measures the number of
units of the good all potential suppliers would be willing to sell at
different prices. (3) When using the market demand curve the
horizontal axis measures the number of units of the good all
potential demanders would be willing to buy at different prices. (4)
There is an implicit time period buried in the units of measurement
74 The ABCs of Political Economy
on the horizontal axis. For example, the supply and demand curves
and the graph will look different if the horizontal axis is measured
in bushels of apples supplied and demanded per week than if it is
measured in bushels of apples supplied and demanded per month.
The “law” of uniform price
The law of uniform price says that all units of a good in a market will
sell at the same price no matter who are the buyers and sellers. This might
seem surprising since some of the deals struck will be between high
cost producers and buyers who are very desirous of the good, and
some of the deals will be struck between low cost producers and
buyers who are lukewarm about buying at all. Nonetheless, the law
of uniform price says a good will tend to sell at the same price no
matter who the seller and buyer may be. The logic of this law can be
illustrated by asking what would happen if some buyers and sellers
were arranging deals at a lower price than others for the same good.
In this case it would pay for anyone to enter the part of the market

where the good was selling at the lower price as a buyer and buy up
all they could, and then enter the part of the market where deals
were being struck at the higher price as a seller to re-sell at a profit.
This activity is called “arbitrage,” and in a free market where any
who wish can participate as buyers or sellers the activity of arbitrage
should drive all deals to be struck at the same price. Where prices
are lower arbitrage increases demand and raises price, and where
prices are higher arbitrage increases supply and lowers price – driving
divergent prices for the same good in a market closer together. Of
course, this assumes that “a rose is a rose is a rose is a rose” in the
words of one of the great French literati, Gertrude Stein – that is, that
there are no qualitative differences between different units of the
good. But subject to this assumption, and the energy levels of those
who would profit from doing nothing other than buying “cheap”
and selling “dear,” economists expect all units of a good that is
bought and sold in a “well ordered” market to sell more or less at
the same price.
The micro “law” of supply and demand
I call the third “law” the micro law of supply and demand to dis-
tinguish it from a different law we study in chapter 6 that I call the
“macro law of supply and demand.” The micro law of supply and
demand states that in a free market the uniform market price will adjust
until the number of units buyers want to buy is equal to the number of
Markets 75
units sellers want to sell. In terms of the supply and demand graph in
Figure 4.1, the micro law of supply and demand says that the market
will settle at the price across from where the market supply and
demand curves cross, and at the quantity bought and sold beneath
where the supply and demand curves cross. This price and this
quantity bought and sold are called the equilibrium price and equilib-

rium quantity, so another way of stating the micro law of supply and
demand is: markets will settle at their equilibrium prices, and if left to
the free market the quantity of any good that will be produced and
consumed will be the equilibrium quantity.
The rationale for the micro law of supply and demand is as
follows: Suppose the going market price, P(1), is higher than the
equilibrium price, P(e). In this case if we read across from this price
to find out how much buyers are willing to buy, Q
D
(1), as compared
to how much suppliers are willing to sell, Q
S
(1), we discover from
the market demand curve and market supply curve that buyers are
not willing to buy all that sellers are willing to sell at this price,
Q
D
(1) < Q
S
(1). In other words, at this price there will be excess supply
in the market for the good. What can we expect sellers to do? In
conditions of excess supply sellers fall into two groups: those who are
happily succeeding in selling their goods at P(1) and those who
cannot sell all they want and are therefore frustrated. Those who are
not able to sell their goods have an incentive to lower their asking
price below the going market price in order to move from the group
of frustrated sellers to the group of successful sellers, thereby driving
the market price down in the direction of the equilibrium price.
Buyers also have an incentive to only agree to buy at a price below
the going market price when they notice there is excess supply in

the market since they know that there are some frustrated sellers out
there who should be willing to accept less than the going market
price, providing another reason why market price should start to fall
in the direction of the equilibrium price.
On the other hand, suppose the going market price, P(2), is lower
than the equilibrium price, P(e). If we read across from this price to
find out how much buyers are willing to buy, Q
D
(2), as compared to
how much suppliers are willing to sell, Q
S
(2), we discover from the
market demand curve and market supply curve that sellers are not
willing to sell all that buyers are willing to buy at this price, Q
S
(2) <
Q
D
(2). In other words, at this price there will be excess demand in
the market for the good. What can we expect buyers to do? In
conditions of excess demand buyers fall into two groups: those who
76 The ABCs of Political Economy
are happily able to buy all the good they want at P(2), and those who
are not able to buy all they want and are therefore frustrated. Those
who are not able to buy all they want have an incentive to raise their
offer price above the going market price in order to move from the
group of frustrated buyers to the group of successful buyers, thereby
driving the market price up in the direction of the equilibrium price.
Sellers also have an incentive to only agree to sell at a price above the
going market price when they notice there is excess demand in the

market since they know that there are some frustrated buyers who
should be willing to pay more than the going market price,
providing another reason why market price should rise in the
direction of the equilibrium price.
So for actual market prices above the equilibrium price there are
incentives for frustrated sellers to cut their asking price and buyers
to offer a lower price, driving the market price down toward the equi-
librium price. And as the market price drops the amount of the
excess supply will decrease since the law of supply says that supply
decreases as price falls and the law of demand says that demand
increases as price falls. And for market prices below the equilibrium
price there are incentives for frustrated buyers to raise their offer
price and for sellers to raise their asking price, driving the market
price up toward the equilibrium price. And as the market price rises
the excess demand will decrease since the law of demand says that
demand decreases as price rises, and the law of supply says that
supply increases as price rises. So according to the micro law of
supply and demand, the only stable price will be the equilibrium
price because self-interested behavior of frustrated sellers or buyers
will lead to changes in price under conditions of both excess supply
and excess demand, and only at the equilibrium price is there
neither excess supply nor excess demand. This particular kind of self-
interested behavior of buyers and sellers – individually rational
responses to finding oneself unable to sell or buy all one wants at
the going market price – can be thought of as “equilibrating forces”
that economists expect to operate in markets. So the micro law of
supply and demand can be thought of as a “law” explaining why
there should be equilibrating forces at work in markets. We will
discover below that market enthusiasts and critics disagree about
how strong these “equilibrating forces” are compared to “disequili-

brating forces” the micro law of supply and demand does not alert
us to that sometimes operate alongside equilibrating forces.
Markets 77
There are a few things worth noting at this point:
1. There are different senses in which buyers or sellers are
“satisfied.” All buyers would always like to pay a lower price, and
all sellers would always like to receive a higher price. So in that
sense, neither buyers nor sellers are ever “satisfied” no matter
what the going price. But when the market price is above the
equilibrium price, while successful sellers will be pleased, there
will be unsuccessful sellers who will be displeased. Moreover,
there is something the non-sellers can do about their frustrations:
they can offer to sell at a lower price. Similarly, when the market
price is below the equilibrium price, while successful buyers will
be pleased, there will be unsuccessful buyers who will be
displeased. And what the non-buyers can do about their frustra-
tions is to offer to pay a higher price.
2. It is always the case that the quantity bought will be equal to the
quantity sold – whether the market is in equilibrium or not. This
follows because every unit that was bought was sold and every
unit that was sold was bought! But that is not the same as saying
that the quantity demanders want to buy is equal to the quantity
suppliers want to sell. There is only one price at which the
quantity demanded will equal the quantity supplied – the equi-
librium price. At all other prices there will be either excess supply
or excess demand.
3. Since not all markets are always in equilibrium, how much will
be bought and sold when a market is out of equilibrium? This is
where the assumption of non-coercion in our definition of a
market enters in: buyers cannot be forced to buy if they don’t

want to and sellers can’t be forced to sell if they don’t want to.
When there is excess supply the sellers would like to sell more
than the buyers want to buy at the going price. So under
conditions of excess supply it is the buyers who have the upper
hand, in a sense, and they will determine how much is going to
be bought, and therefore sold. In Figure 4.1 when market price is
P(1) and there is excess supply buyers will only buy Q
D
(1) and
therefore, that is all sellers, will be able to sell. When there is
excess demand the buyers would like to buy more than the sellers
want to sell. So under conditions of excess demand it is the sellers
who have the upper hand and will determine how much is going
to be sold, and therefore bought. In Figure 4.1 when market price
is P(2) and there is excess demand sellers will only sell Q
S
(2) and
therefore, that is all buyers will be able to buy.
78 The ABCs of Political Economy
Elasticity of supply and demand
The law of demand just says that as price rises we expect the quantity
demanded to fall. It doesn’t say whether demand will fall a lot or a
little. If a 1% increase in price leads to more than a 1% fall in quantity
demanded, we say that market demand is elastic. If a 1% increase in price
leads to less than a 1% fall in quantity demanded, we say that market
demand is inelastic. Similarly, the law of supply just says that as price
rises we expect the quantity supplied to rise; it doesn’t say whether
supply will rise a lot or a little. If a 1% increase in price leads to more
than a 1% rise in quantity supplied, we say that market supply is
elastic. If a 1% increase in price leads to less than a 1% rise in

quantity supplied, we say that market supply is inelastic.
The elasticity of supply and demand allows us to predict how
much the supply and demand for goods will change when their price
changes. Elasticity also holds the key to how revenues of sellers will
be affected by changes in supply. For example, the demand for corn
is usually elastic. So when a drought hits the corn belt the price will
rise and the equilibrium quantity bought and sold will fall. But the
percentage fall in sales will be greater than the percentage increase
in price because demand for corn is elastic. Since the revenue of corn
farmers is simply equal to the market price times the quantity sold,
the fact that sales drop by a greater percent than the increase in price
means revenues must fall. On the other hand, the demand for oil is
usually inelastic. So if war breaks out in the Middle East and a
country such as Iraq, Kuwait, Iran, Libya, or Saudi Arabia is tem-
porarily eliminated as a potential supplier the price will rise and the
equilibrium quantity bought and sold will fall as before. But because
demand for oil is inelastic the percentage fall in sales will be less than
the percentage increase in price. In this case the revenue of oil
suppliers will increase because the rise in price outweighs the drop
in sales when supply decreases.
You can use your understanding of elasticity to predict whether
more or less unemployment will result from minimum wage laws,
and whether more or fewer shortages will result from price controls.
Draw a labor market diagram with one “flat” (elastic) labor demand
curve and one “steep” (inelastic) labor demand curve where both
demand curves cross the labor supply curve at the same point.
Where both demand curves cross the supply curve determines the
equilibrium wage rate and the equilibrium level of employment.
Now draw in a minimum wage above the equilibrium wage and see
Markets 79

what happens to employment as buyers (employers) determine the
quantity that will be bought and sold in a market with excess supply.
Notice that the drop in employment is greater if the demand for
labor is more elastic, and smaller if the demand for labor is more
inelastic. Draw a diagram for the steel market with one “flat” or
elastic supply curve and one “steep” or inelastic supply curve where
both supply curves cross the demand curve for steel at the same
point. Where both supply curves cross the demand curve determines
the equilibrium price of steel and the equilibrium quantity of steel
production. Now draw a price ceiling below the equilibrium price
and see what happens to production when suppliers determine the
amount that will be sold and bought in a market with excess
demand. Notice that the drop in production and shortage is greater
if the supply of steel is more elastic and smaller if the supply of steel
is more inelastic.
The principal factors that determine the elasticity of market
demand are the availability and closeness of substitutes for the good,
and the organization and bargaining power of potential buyers. The
principal factors that determine the elasticity of market supply are
the mobility of productive factors into and out of the industry and
the organization and bargaining power of potential sellers.
THE DREAM OF A BENEFICENT INVISIBLE HAND
Adam Smith noticed something strange but wonderful about free
markets. He saw competitive markets as a kind of beneficent,
“invisible hand” that guided “the private interests and passions of
men” in the direction “which is most agreeable to the interest of the
whole society.” Smith expressed this view, in perhaps the most
widely quoted passage in all of economics in The Wealth of Nations
published in 1776:
Every individual necessarily labours to render the annual revenue

of the society as great as he can. He generally, indeed, neither
intends to promote the public interest, nor knows how much he
is promoting it. He intends only his own gain, and he is in this,
as in many other cases, led by an invisible hand to promote an end
which was no part of his intention. Nor is it always the worse for
the society that it was no part of it. By pursuing his own interest
he frequently promotes that of the society more effectually than
80 The ABCs of Political Economy
when he really intends to promote it It is not from the benev-
olence of the butcher, the brewer, or the baker that we expect our
dinner, but from their regard to their self-interest. We address
ourselves, not to their humanity, but to their self-love, and never
talk to them of our necessities, but of their advantages.
In the words of Robert Heilbroner: “Adam Smith’s laws of the market
are basically simple. They show us how the drive of individual self-
interest in an environment of similarly motivated individuals will
result in competition; and they further demonstrate how competi-
tion will result in the provision of those goods that society wants,
in the quantities that society desires.”
1
But how does this miracle
happen?
Suppose consumers’ taste for apples increases and their taste for
oranges decreases – for whatever reason. Assuming consumers know
best what they like, how would we want the economy to respond to
this new situation? If there were an omniscient, beneficent God in
charge of the economy she would shift some of our scarce productive
resources – land, labor, fertilizer, etc. – out of orange production and
into apple production. What would a system of free markets do?
These changes in consumer tastes would shift the market demand

curve for apples out to the right indicating that consumers now
would demand more apples at each and every price of apples than
before, and the market demand curve for oranges back to the left
indicating that consumers would now demand fewer oranges at each
and every price than before – leading to excess demand for apples
and excess supply of oranges at their old equilibrium prices. The
micro law of supply and demand would drive the price of apples up
until the excess demand for apples was eliminated and the price of
oranges down until the excess supply of oranges was eliminated. At
the new higher price of apples, the law of supply tells us that former
apple growers, and any new ones drawn into the industry by the
higher price of apples, would increase production of apples by
purchasing more land, labor, fertilizer, etc. At the new lower price of
oranges the law of supply tells us that orange growers would decrease
their production of oranges by using less land, labor, and fertilizer,
etc. to grow oranges. Bingo! As if guided by an invisible hand,
without anyone thinking or planning at all, the free market does
what a beneficent God would have done for us!
Markets 81
1. Robert Heilbroner, The Worldly Philosophers (Simon and Schuster, 1992): 55.
Or, suppose agronomists develop a new strain of apple that can
be grown with less land between trees than before. This is a technical
change that reduces the amount of scarce productive resources it
takes to grow apples compared to the past. An omniscient,
beneficent God would have consumers buy more apples and fewer
oranges now that apples are less socially costly. What will free
markets do? The cost-reducing change in apple growing technology
will shift the market supply curve for apples out to the right because
now apple growers can cover the cost of growing more apples than
before at each and every price – producing an excess supply of apples

at the old equilibrium price. The micro law of supply and demand
will lower apple prices until the excess supply is eliminated and we
reach the new equilibrium in the apple market. And the law of
demand tells us that consumers will buy more apples at the lower
price. Meanwhile, over in the orange market, the fall in the price of
apples leads some fruit buyers to substitute apples for oranges which
shifts the demand curve for oranges back to the left indicating that
fewer oranges will be demanded at each and every price of oranges
now that the price of apples is lower – creating excess supply in the
orange market. This will lead to a fall in the price of oranges and
lower levels of orange production. Bingo! The free market will bring
about an increase in apple production and consumption and a
decrease in orange production and consumption when the social
cost of producing apples decreases relative to the social cost of
producing oranges – just what we would have wanted to happen.
We can combine Figure 2.2: The Efficiency Criterion (p. 33) and
Figure 4.1: Supply and Demand (p. 73) to see what Smith’s
conclusion that markets harness individually rational behavior to
yield socially rational outcomes amounts to. According to the micro
law of supply and demand, the market outcome will be the equilib-
rium outcome, and the number of apples produced and consumed
can be found directly below where the market supply curve crosses
the market demand curve. According to the efficiency criterion the
optimal number of apples to produce and consume can be found
directly below where the marginal social cost curve crosses the
marginal social benefit curve. So the market outcome will yield the
socially efficient outcome if and only if the market supply curve
coincides with the MSC curve and the market demand curve
coincides with the MSB curve. Another way to put it is that if and
only if market supply closely approximates marginal social cost and

82 The ABCs of Political Economy
market demand closely approximates marginal social benefits will
free market outcomes be socially efficient outcomes.
But do market supply and demand reasonably express marginal
social costs and benefits? That is one way to see the debate between
those who see market allocations as being guided by an invisible
hand versus those who see them as being misguided by an invisible
foot. If market supply and demand closely approximate true marginal
social costs and benefits then the individually rational behavior of
buyers and sellers and the workings of the micro law of supply and
demand would be working in the social interest because they would
be driving production and consumption of goods and services toward
socially efficient levels. Moreover, whenever conditions changed
social costs or benefits these equilibrating forces would move us to
the new socially efficient outcome. In other words, markets would
yield efficient allocations of scarce productive resources. On the other
hand, if there are significant discrepancies between market supply
and marginal social costs and/or market demand and marginal social
benefits, individually rational behavior of buyers and sellers and the
micro law of supply and demand work against the social interest by
driving us to produce too little of some goods and too much of
others. In other words, by relying on market forces we would con-
sistently get inefficient allocations of productive resources.
Mainstream and political economists agree on one part of the
answer before parting company. They agree that what market supply
captures and represents are the costs born by the actual sellers of goods
and services; and what market demand represents are the benefits enjoyed
by the actual buyers of goods and services. We call these “private costs”
and “private benefits.” A rational buyer will keep buying a good as
long as the private benefit to her of an additional unit is at least as

great as the price she must pay for it. In other words, her marginal
private benefit curve is her individual demand curve. Since the
market demand curve is simply the summation of all individual
demand curves, the market demand curve is simply the sum of all
marginal private benefit curves. A rational seller will keep selling as
long as the cost to her of producing another unit of output is no
greater than the price she will get from selling it. In other words, her
marginal private cost curve is her individual supply curve. Since
market supply is simply the summation of all individual supply
curves, the market supply curve is simply the sum of all marginal
private cost curves. So the question becomes: When do private costs
and benefits differ from social costs and benefits?
Markets 83
In fairness to Adam Smith, the distinction between private and
social costs and benefits was not clear in his lifetime. Smith, and
“classical economists” who lived and wrote after him as well,
conflated social and private costs and benefits and never asked if
anyone other than the seller bore part of the cost of increased
production, or anyone other than the buyer enjoyed part of the
benefit of increased consumption of different kinds of goods and
services. The modern terminology for differences between social and
private costs of production is “a production externality.” And the
name for the difference between social and private benefits from con-
sumption is “a consumption externality.” These “external effects”
can be negative if someone other than the seller suffers a cost
associated with production so social costs exceed private costs, or if
someone other than the buyer is adversely affected by the buyer’s
consumption so private benefits exceed social benefits. Or external
effects can be positive if the private costs of production exceed the
social costs or social benefits of consumption exceed private benefits.

Adam Smith’s vision of the market as a mechanism that successfully
harnesses individual desires to the social purpose of using scarce
productive resources efficiently hinges on the assumption that
external effects are insignificant. And, indeed, this is precisely the
un-emphasized assumption that lies behind the mainstream
conclusion that markets are remarkable efficiency machines that
require little social effort on our part. In fact, the mainstream view
today is a strident echo of Adam Smith’s conclusion that the only
“effort” required is the “effort” to resist the temptation to tamper
with the free market place and simply: “laissez faire.”
THE NIGHTMARE OF A MALEVOLENT INVISIBLE FOOT
Mainstream economic theory teaches that the problem with exter-
nalities is that the buyer or seller has no incentive to take the
external cost or benefit for others into account when deciding how
much of something to supply or demand. And Mainstream theory
teaches that the “problem” with public goods is that nobody can be
excluded from benefitting from a public good once anyone buys it,
and therefore everyone has an incentive to “ride for free” on the
purchases of others rather than revealing their true willingness to
pay for public goods by purchasing them in the market place. In
other words, mainstream economics concedes that the laws of the
market place will lead to inefficient allocations of scarce productive
84 The ABCs of Political Economy
resources when public goods and externalities come into play
because important benefits or costs go unaccounted for in the
market decision making process. If anyone cares to listen, standard
economic theory predicts that market forces will lead us to produce
too much of goods whose production and/or consumption entail
negative externalities, too little of goods whose production and/or
consumption entail positive externalities, and much too little, if any,

public goods. We can see the problem of negative externalities by
looking at the automobile industry, and the problem of public goods
by considering pollution reduction.
Externalities: the auto industry
The micro law of supply and demand tells us how many cars will be
produced and consumed if we leave the decision to the free market.
The price of cars will adjust until there is neither excess supply nor
excess demand at which point the “equilibrium” number of cars will
be produced and consumed. The question is whether or not this is
more, less, or the same number of cars that is socially efficient, or
optimal to produce and consume. As we saw, the socially efficient
level of auto production and consumption is where the MSB curve
crosses the MSC curve. If the market supply curve for cars coincides
with the MSC curve for cars, and if the market demand curve for cars
coincides with the MSB curve for cars, the market outcome will be
the efficient outcome. Otherwise, it will not.
Let us assume that the market supply curve for cars does a
reasonably good job of approximating the marginal private costs the
makers and sellers of cars incur. That is, we will assume that if car
manufacturers can get a price for a car that is something above what
it costs them to make it, they will produce and sell the car. In this
case the market supply curve, S, closely approximates the marginal
private cost (MPC) curve for making cars: S = MPC. But if there are
costs to external parties above and beyond the costs of inputs car
makers must pay for, there is no reason to expect the car makers to
take them into account. So if the corporations making cars in Detroit
also pollute the air in ways that cause acid rain, the costs that take
the form of lost benefits to those who own, use, or enjoy forests and
lakes in Eastern Canada and the United States will not be taken into
account by those who make the decisions about how many cars to

produce. Nevertheless, along with the cost of steel, rubber and labor
needed to make a car – which are costs borne by car manufacturers
– the costs of acid rain are part of the social costs of making cars even
Markets 85
if they are not borne by car makers. To the cost of steel, rubber, and
labor that comprise the private costs of making a car, must be added
the damage from acid rain that occurs when we make a car if we are
to have the full cost to society of making another car. In other words,
the marginal social cost of making a car, MSC, is equal to the
marginal private cost of making the car, MPC, plus the marginal
external costs associated with making the car, MEC: MSC = MPC +
MEC. Since MEC is positive for automobile production, marginal
social cost always exceeds marginal private cost, which means the
marginal social cost curve for producing cars lies somewhere above
the marginal private cost curve for making cars, which is, in turn,
roughly equal to the market supply curve for cars: MSC = MPC +
MEC = S + MEC with MEC > 0.
When car buyers consider whether or not to purchase a car they
presumably compare the benefit they expect to get in the form of
ease and speed of transportation with the price they will have to pay
out of their limited income. If the private benefit exceeds the price,
they will buy the car, and if it does not, they won’t. This means the
market demand curve, D, represents the marginal private benefit
curve from car consumption, MPB, reasonably well: D = MPB. But I
am not the only person affected when I “consume” my car. When I
drive my car the exhausts add to the “greenhouse” gases in the
atmosphere and contribute to global warming. When I drive from
the suburbs through inner city neighborhoods I contribute to urban
smog, noise pollution, and congestion. In other words, when I
consume a car there are others who suffer negative benefits which

means that the social benefit of consuming another car is less than
the private benefit of consuming another car. So even if the market
demand curve for cars reasonably represents the marginal private
benefits of car consumption, it overestimates the marginal social
benefits of car consumption because it ignores the negative impact
of car consumption on those not driving them. The marginal social
benefits from consuming another car, MSB, is equal to the marginal
private benefits to the car buyer plus the marginal external benefits
to others, MEB: MSB = MPB + MEB. But in the case of car consump-
tion the marginal external “benefits,” MEB, are negative. This implies
that the marginal social benefit curve lies somewhere below the
market demand curve for automobiles: MSB = MPB + MEB = D + MEB
with MEB < 0.
86 The ABCs of Political Economy
But as can be seen in Figure 4.2, if the MSC curve lies above the
market supply curve, and the MSB curve lies below the market
demand curve for cars, MSC and MSB will cross to the left of where
the market supply and demand curves cross. Therefore the socially
efficient, or optimal level of automobile production (and consump-
tion), A(0), will be less than the equilibrium level of production and
consumption, A(e), that the micro law of supply and demand will
drive us toward. In other words, the market will lead us to produce
and consume more cars than is socially efficient, or optimal. The
market will lead to too much car production and consumption
because sellers and buyers decide how many cars to produce and
consume and they have no reason to take anything other than the
costs and benefits to them into account. They have no incentive to
consider the external costs associated with producing and
consuming cars. In fact, they have good reason to ignore these
external effects because taking them into account would make them

individually worse off. Not surprisingly we discover that if decision
makers ignore negative consequences of doing something – in this
case the negative external effects of car production and consump-
tion on people other than the car producer and buyer – they will
Markets 87
Figure 4.2 Inefficiencies in the Automobile Market
decide to do too much of it – in this case they will decide to produce
and consume too many cars.
2
Public goods: pollution reduction
A public good is a good produced by human economic activity that
is consumed, to all intents and purposes, by everyone rather than
by an individual consumer. Unlike a private good such as underwear
that affects only its wearer, public goods like pollution reduction
affect most people. In different terms, nobody can be excluded from
“consuming” a public good – or benefitting from the existence of
the public good. This is not to say that everyone has the same pref-
erences regarding public goods anymore than people have the same
preferences for private goods. I happen to prefer apples to oranges,
and I value pollution reduction more than I value so-called “national
defense.” There are others who place greater value on “national
defense” than they do on pollution reduction, just as there are others
who prefer oranges to apples. But unlike the case of apples and
oranges where those who prefer apples can buy more apples and
those who like oranges more can buy more oranges, all US citizens
have to “consume” the same amount of federal spending on the
military and federal spending on pollution reduction. We cannot
provide more military spending for the US citizens who value that
public good more, and more pollution reduction for the US citizens
who value the environment more. Whereas different Americans can

consume different amounts of private goods, we all must live in the
same “public good world.”
What would happen if we left the decision about how much of
our scarce productive resources to devote to producing public goods
to the free market? Markets only provide goods for which there is
what we call “effective demand,” that is, buyers willing and able to
put their money where their mouth is. But what incentive is there for
a buyer to pay for a public good? First of all, no matter how much I
88 The ABCs of Political Economy
2. External effects are notoriously hard to measure in market economies.
This is of great significance since their magnitude is critical to how inef-
ficient a market will be, and how large a pollution tax needs to be to correct
the inefficiency. In a 1998 report the Center for Technology Assessment
estimated that when external effects are taken into account the true social
cost of a gallon of gasoline consumed in the US may be as high as $15. I
just paid $1.02 a gallon when I filled my car up today in southern Maryland.
The $1.02 already includes some hefty taxes, but obviously they are not
nearly hefty enough!
value the public good, I only enjoy a tiny fraction of the overall, or
social benefit that comes from having more of it since I cannot
exclude others who do not pay for it from benefitting as well. In
different terms: Social rationality demands that an individual
purchase a public good up to the point where the cost of the last unit
she purchased is as great as the benefits enjoyed by all who benefit,
in sum total, from her purchase of the good. But it is only rational for
an individual to buy a public good up to the point where the cost of
the last unit she purchased is as great as the benefit she, herself,
enjoys from the good. When individuals buy public goods in a free
market they have no incentive to take the benefits others enjoy into
account when they decide how much to buy. Consequently they

“demand” far less than is socially efficient, if they purchase any at all.
In sum, market demand will grossly under-represent the marginal
social benefit of public goods.
Another way to see the problem is to recognize that each potential
buyer of a public good has an incentive to wait and hope that
someone else will buy the public good. A patient buyer can “ride for
free” on others’ purchases since non-payers cannot be excluded from
benefitting from public goods. But if everyone is waiting for
someone else to plunk down their hard earned income for a public
good, nobody will demonstrate “effective demand” for public goods
in the market place. “Free riding” is individually rational in the case
of public goods – but leads to an “effective demand” for public goods
that grossly underestimates their true social benefit. In chapter 5 we
explore this logic formally in “the public good game.”
What prevents a group of people who will benefit from a public
good from banding together to express their demand for the good
collectively? The problem is that there is an incentive for people to
lie about how much they benefit. If the associations of public good
consumers are voluntary, no matter how much I truly benefit from
a public good, I am better off pretending I don’t benefit at all. Then
I can decline membership in the association and avoid paying
anything, knowing full well that I will, in fact, benefit from its
existence nonetheless. If the associations are not voluntary – i.e., if
a government “drafts” people into the public good consuming
coalition – there is still an incentive for people to under-represent
the degree to which they benefit if assessments are based on degree
of benefit. This is where the fact that not all people do benefit equally
from different kinds of public goods becomes an important part of
the problem. If we knew that everyone truly valued a larger military
Markets 89

to the same extent, there would be few objections to making
everyone contribute the same amount to pay for it. But there is every
reason to believe this is not the case. In this context, if we believe
that payments should be related to the degree to which someone
benefits, there is an incentive for everyone to pretend they benefit
less than they do. If the effective demand expressed by the non-
voluntary consuming coalition is based on these individually
rational under-representations, it will still significantly under-
represent the true social benefits people enjoy from the public good,
and consequently lead to less demand for the public good than is
socially efficient, or optimal.
In sum, because of what economists call the “free rider” incentive
problem and the “transaction costs” of organizing and managing a
coalition of public good consumers, market demand predictably
under-represents the true social benefits that come from consump-
tion of public goods. If the production of a public good entails no
external effects so the market supply curve accurately represents the
marginal social costs of producing the public good, then since market
demand will lie considerably under the true marginal social benefit
curve for the public good, the market equilibrium level of production
and consumption will be significantly less than the socially efficient
level. In conclusion, if we left it to the free market and voluntary
associations precious little, if any, of our scarce productive resources
would be used to produce public goods no matter how valuable they
really were. As Robert Heilbroner put it: “The market has a keen ear
for private wants, but a deaf ear for public needs.”
The fact that pollution reduction is a public good has important
implications for green consumerism in free market economies. There
are a number of cheap detergents that get my wash very white but
cause considerable water pollution. “Green” detergents, on the other

hand, are more expensive and leave my whites more gray than
white, but cause less water pollution. Whether or not I end up making
the socially responsible choice, because pollution reduction is a public
good the market provides too little incentive for me to make the
socially efficient choice. My own best interests are served by
weighing the disadvantage of the extra cost and grayer whites to me
against the advantage to me of the diminution in water pollution
that would result if I use the green detergent. But presumably there
are many others besides me who also benefit from the cleaner water
if I buy the green detergent – which is precisely why we think of
“buying green” as socially responsible behavior. Unfortunately the
90 The ABCs of Political Economy
market provides no incentive for me to take their benefit into
account. Worse still, if I suspect others may consult only their own
interests when they choose which detergent to buy, i.e., if I think
they will ignore the benefits to me and others if they choose the
“green” detergent, by choosing to take their interests into account
and consuming green myself I risk not only making a choice that
was detrimental to my own interests, I risk being played for a sucker
as well.
3
This is not to say that many people will not choose to “do the
right thing” and “consume green” in any case. Moreover, there may
be incentives other than the socially counterproductive market incentives
that may overcome the market disincentive to consume green. The
fact that I am a member of the Southern Maryland Green Party and
fear I would be ostracized if observed by a fellow party member with
a polluting detergent in my shopping basket in the check out line at
the supermarket is apparently a powerful enough incentive in my
own case to lead me to buy a green detergent despite the market dis-

incentive to do so. (Admittedly I have only a slight preference for
white over gray clothes, and who knows how long I will hold out if
the price differential increases?) But the point is that because
pollution reduction is a public good, market incentives are perverse,
i.e. lead people to consume less “green” and more “dirty” than is
socially efficient. The extent to which people ignore the perverse
market incentives and act on the basis of concern for the environ-
ment, concern for others, including future generations, or in
response to non-market, social incentives such as fear of ostracism
is important for the environment and the social interest, but does
not make the market incentives any the less perverse.
The prevalence of external effects
In face of these concessions – markets misallocate resources when
there are externalities and public goods – how do market enthusi-
asts continue to claim that markets allocate resources efficiently – as
if guided by a beneficent invisible hand? The answer lies in an
assumption that is explicit in the theorems of graduate level micro
Markets 91
3. Most detergents call for a full cup per load of wash. Church & Dwight
canceled a
1
⁄4 cup laundry detergent product when consumer demand for
this “green” product proved insufficient. See Christine Canning, “The
Laundry Detergent Market,” in Household and Personal Products Industry,
April 1996.
economic theory texts but only implicit in undergraduate textbooks
and in the advice of most economists. The fundamental theorem of
welfare economics states that if all markets are in equilibrium the
economy will be in a Pareto optimal state only if there are no external
effects or public goods. The assumption that there are no public goods

or external effects is explicit in the statement of the theorem that is
the modern incarnation of Adam Smith’s 200-year-old vision of an
invisible hand – because otherwise the theorem would be false! Since
everyone knows there are externalities and public goods in the real
world, the conclusion that markets allocate resources reasonably effi-
ciently in the real world rests on the assumption that external effects
and public goods are few and far between. This assumption is usually
unstated, and its validity has never been demonstrated through
empirical research. It is a presumption implicit in an untested
paradigm that lies behind mainstream economic theory – a
paradigm that pretends that the choices people make have little
effect on the opportunities and well being of others.
If we replace the implicit paradigm at the basis of mainstream
economics with one that sees the world as a web of human interac-
tion where people’s choices often have far reaching consequences
for others, both now and in the future, the presumption that
external effects and public goods are the exception rather than the
rule is reversed. Since political economists have long seen the world
in just this way, and everything we have learned about the relation
between human choices and ecological systems over the past 30
years reinforces this vision of interconnectedness, there is every
reason for political economists to expect external and public effects
to be the rule rather than the exception. What is surprising is that so
few political economists have recognized the far reaching implica-
tions of their own beliefs when it comes to assessing the efficiency
of markets. One stellar exception is E.K. Hunt. In an article “On
Lemmings and Other Acquisitive Animals” remarkable for its lack of
impact on other political economists when published in June 1973
(Journal of Economic Issues), E.K. Hunt stated the “reverse”
assumption as follows:

The Achilles heel of welfare economics [as practiced by
mainstream pro-market economists] is its treatment of externali-
ties When reference is made to externalities, one usually takes
as a typical example an upwind factory that emits large quantities
of sulfur oxides and particulate matter inducing rising probabili-
ties of emphysema, lung cancer, and other respiratory diseases to
92 The ABCs of Political Economy
residents downwind, or a strip-mining operation that leaves an
irreparable aesthetic scar on the countryside. The fact is, however,
that most of the millions of acts of production and consumption
in which we daily engage involve externalities. In a market
economy any action of one individual or enterprise which induces
pleasure or pain to any other individual or enterprise consti-
tutes an externality. Since the vast majority of productive and
consumptive acts are social, i.e., to some degree they involve more
than one person, it follows that they will involve externalities.
Our table manners in a restaurant, the general appearance of our
house, our yard or our person, our personal hygiene, the route we
pick for a joy ride, the time of day we mow our lawn, or nearly
any one of the thousands of ordinary daily acts, all affect, to some
degree, the pleasures or happiness of others. The fact is exter-
nalities are totally pervasive Only the most extreme bourgeois
individualism could have resulted in an economic theory that
assumed otherwise.
If the social effects of production and consumption frequently
extend beyond the sellers and buyers of those goods and services, as
Hunt argues above, and if these external effects are not insignificant,
markets will frequently misallocate resources leading us to produce
too much of some goods and too little of others. By ignoring
negative external effects markets lead us to produce and consume

more of goods like automobiles than is socially efficient. By ignoring
positive external effects markets lead us to consume less of goods
like tropical rain forests that recycle carbon dioxide and thereby
reduce global warming than is socially efficient – instead we clear
cut them or burn them off to pasture cattle. And while markets
provide reasonable opportunities for people to express their prefer-
ences for goods and services that can be enjoyed individually with
minimal “transaction costs,” they do not provide efficient means for
expressing desires for goods that are enjoyed, or consumed socially,
or collectively – like public space and pollution reduction. Markets
create “free rider” disincentives for those who would express their
desires for public goods individually, and pose daunting transaction
costs for those who attempt to form a coalition of beneficiaries. In
other words, markets have an anti-social bias.
Worse still, markets provide powerful incentives for actors to take
advantage of external effects in socially counterproductive ways, and
even to magnify or create new ones. Increasing the value of goods
Markets 93
and services produced, and decreasing the unpleasantness of what
we have to do to get them, are two ways that producers can increase
their profits in a market economy. And competitive pressures will
drive producers to do both. But maneuvering to appropriate a greater
share of the goods and services produced by externalizing costs and
internalizing benefits without compensation are also ways to
increase profits. Competitive pressures will drive producers to pursue
this route to greater profitability just as assiduously. Of course the
problem is, while the first kind of behavior serves the social interest
as well as the private interests of producers, the second kind of
behavior does not. Instead, when buyers or sellers promote their
private interests by externalizing costs onto those not party to the

market exchange, or internalizing benefits without compensating
external parties, their “rent seeking behavior” introduces inefficien-
cies that lead to a misallocation of productive resources and
consequently decreases the value of all the goods and services
produced. Questions market admirers seldom ask are: Where are
firms most likely to find the easiest opportunities to expand their
profits? How easy is it to increase the quantity or quality of goods
produced? How easy is it to reduce the time or discomfort it takes to
produce them? Alternatively, how easy is it to enlarge one’s slice of
the economic pie by externalizing a cost, or by appropriating a
benefit without compensation? In sum, why should we assume that
it is infinitely easier to expand profits by productive behavior than
by rent seeking behavior? Yet this implicit assumption is what lies
behind the view of markets as efficiency machines.
Market enthusiasts fail to notice that the same feature of market
exchanges primarily responsible for small transaction costs –
excluding all affected parties but two from the transaction – is also
a major source of potential gain for the buyer and seller. When the
buyer and seller of an automobile strike their convenient deal, the
size of the benefit they have to divide between them is greatly
enlarged by externalizing the costs onto others of the acid rain
produced by car production, and the costs of urban smog, noise
pollution, traffic congestion, and greenhouse gas emissions caused
by car consumption. Those who pay these costs, and thereby enlarge
car maker profits and car consumer benefits, are “easy marks” for car
sellers and buyers because they are geographically and chronologi-
cally dispersed, and because the magnitude of the effect on each of
them is small and unequal. Individually they have little incentive to
94 The ABCs of Political Economy
insist on being party to the transaction. Collectively they face trans-

action cost and free rider obstacles to forming a voluntary coalition
to represent a large number of people – each with little, but different,
amounts at stake.
Moreover, the opportunity for socially counterproductive rent
seeking behavior is not eliminated by making markets perfectly com-
petitive or entry costless, as is commonly assumed. Rent seeking at
the expense of a buyer or seller may be eliminated by competitive
markets, i.e. the presence of innumerable sellers for buyers to choose
from and innumerable buyers for sellers to choose from. But even if
there were countless perfectly informed sellers and buyers in every
market, even if the appearance of the slightest differences in average
profit rates in different industries induced instantaneous self-
correcting entries and exits of firms, even if every market participant
were equally powerful and therefore equally powerless – in other
words, even if we embrace the full fantasy of market enthusiasts –
as long as there are numerous external parties with small but
unequal interests in market transactions, those external parties will
face greater transaction cost and free rider obstacles to a full and
effective representation of their collective interest than any obstacles
faced by the buyer and seller in the exchange. And it is this unavoid-
able inequality that makes external parties easy prey to rent seeking
behavior on the part of buyers and sellers. Even if we could organize
a market economy so that buyers and sellers never faced a more or
less powerful opponent in a market exchange, this would not change
the fact that each of us has smaller interests at stake in many trans-
actions in which we are neither the buyer nor seller. Yet the sum total
interest of all external parties can be considerable compared to the
interests of the buyer and the seller. It is the transaction cost and free
rider problems of those with lesser interests that create an unavoid-
able inequality in power, which, in turn, gives rise to the opportunity

for individually profitable but socially counterproductive rent
seeking on the part of buyers and sellers in even the most competi-
tive markets. A sufficient condition for buyers and sellers to profit
in socially counterproductive ways from maneuvering, rent seeking,
or cost shifting behavior is that each one of us has diffuse interests
that make us affected external parties to many exchanges in which
we are neither buyer nor seller – no matter how competitive markets
may be.
Markets 95